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Options for Avoiding Carbon Leakage

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Options for Avoiding Carbon Leakage 21 Options for avoiding carbon leakage Carolyn Fischer Resources for the Future Carbon leakage – the increase in foreign emissions that results as a consequence of domestic actions to reduce emissions – is of particular concern for countries seeking to put a substantial price on carbon ahead of their trading partners. While energy market reactions to changes in global fossil fuel demand are difficult to avoid, absent a global price on carbon, some options are available to address leakage associated with changes in competitiveness of energy-intensive, trade-exposed industries. This chapter discusses the main legal and economic trade-offs regarding the use of exemptions, output-based rebating, border carbon adjustment, and sectoral agreements. The potential for clean technology policies to address the energy market channel is also considered. Ultimately, unilateral policies have only unilateral options for addressing carbon leakage, resulting in weak carbon prices, a reluctance to go first and, for those willing to forge ahead, an excessive reliance on regulatory options that in the long run are much more costly means of reducing emissions than carbon pricing. Recognising those costs, if enough major economies could agree on a coordinated approach to carbon pricing that spreads coverage broadly enough, carbon leakage would become less important an issue. Furthermore, a multilateral approach to anti-leakage measures can better ensure they are in harmony with other international agreements. If anti-leakage measures can support enough adherence to ambitious emissions reduction programmes, they can contribute to their own obsolescence. 297 Towards a Workable and Effective Climate Regime 1 Introduction Carbon leakage is a chief concern for governments seeking to implement ambitious emissions reduction policies – particularly those that place high prices on carbon – ahead of similar actions on the part of their major trading partners. ‘Emissions leakage’ is generally defined as the increase in foreign emissions that results as a consequence of domestic actions to reduce emissions. Since greenhouse gases (GHGs) are global pollutants, emissions leakage in the case of carbon is a particular concern, as it directly undermines the benefits of the domestic emissions reductions. Carbon leakage from economy-wide carbon pricing policies in major economies is centrally estimated by global trade models to range between 5% and 30%.1 Higher rates are associated with smaller coalitions, higher carbon prices, more substitution through trade, and stronger energy market responses. Sector-specific carbon leakage rates can be much higher, as well – as much as three to five times the economy-wide leakage rate.2 Carbon leakage occurs through multiple channels. The largest one, as indicated by the modelling literature, is the energy market channel. The idea is that if a major economy on its own withdraws a lot of demand for fossil fuels, the global prices for those fuels become depressed. As a consequence of cheaper prices, other countries consume more fossil fuels and their economies become more carbon intensive. Figure 1 illustrates this form of carbon leakage with global supply and demand curves for fossil fuels. If a coalition of countries adopts carbon pricing, their demand (and thus global demand) for fossil fuels shifts inward. If the price did not change, the quantity that suppliers offer would exceed the quantity demanded at that price; thus, the price falls to find a new market equilibrium. However, since demand in the rest of the world (ROW) has not changed, they consume more at the new lower price. Therefore, the net reduction in global consumption is less than the reduction in coalition consumption. 1 Readers interested in more detail can see an Energy Modeling Forum exercise on carbon leakage and border carbon adjustments (EMF 29), published as a Special Issue of Energy Economics (Böhringer et al. 2012). 2 Fischer and Fox (2012). 298 Options for avoiding carbon leakage Carolyn Fischer Figure 1 Carbon leakage from demand and supply responses in energy markets ROW demand Fossil fuel Global price supply Global demand Global demand with coalition carbon price ROW Total consumption consumption Leakage The reasoning is the same as many explanations for the drop in oil prices and their consequences over the past year: growth in worldwide demand has been lower than expected, and now lower gasoline prices are encouraging more sales of SUVs, which have higher fuel consumption rates. Importantly, the energy market channel operates via any changes in demand for fossil fuels, whether due to carbon pricing or regulation and energy efficiency. The channel for carbon leakage that causes the greatest concern for policymakers, however, is the ‘competitiveness’ channel. This channel relates to policies – like carbon pricing – that pass on higher energy costs to energy-intensive, trade-exposed (EITE) industries, making manufacturing in carbon-pricing countries less competitive. This causes economic activity, market share, and, in the longer run, investments in those sectors to shift abroad to jurisdictions with lower energy costs. Modelling results indicate that one-quarter to one-half of carbon leakage occurs through competitiveness effects. This channel is somewhat narrower than the energy market channel, as it primarily affects specific industrial sectors that represent a small share of the economy,3 but they have outsized effects on emissions leakage, and may also wield outsized political influence. 3 In the case of the US, industries with energy expenditures in excess of 5% of the value of their output account for only one-tenth of the value of US manufacturing output and less than 2% of US GDP (Fischer et al. 2014). 299 Towards a Workable and Effective Climate Regime A third channel, the induced innovation channel, has the potential to create negative leakage in the long term. If carbon mitigation policies induce innovation in clean energy technologies, lowering their costs globally, all countries will find them more attractive. Greater adoption of clean technologies in countries with low or no carbon prices will help displace fossil fuels and further reduce global emissions. On the other hand, countries with low carbon prices that become more competitive in energy-intensive sectors may see their technical change directed towards energy-using technologies, exacerbating carbon leakage. Thus far, this innovation channel has been theorised (e.g. Gerlagh and Kuik 2014) but empirical evidence of its scope is lacking. 1.1 Carbon pricing and carbon leakage Understanding these different channels informs how we evaluate the options for addressing carbon leakage. Clearly, the best option for reducing emissions while addressing all channels of leakage would be to have harmonised carbon prices worldwide. Of course, this is not a likely outcome of the current framework for INDCs, although such commitments would certainly not be precluded. Several prominent economists are advocating for forming a club of major economies with minimum carbon prices (see, for example, Nordhaus 2015, Gollier and Tirole 2015, Weitzman 2013). The challenge is that options for dealing with carbon leakage unilaterally are more limited. One, unfortunately, is simply to set lower carbon prices – that creates less pressure for leakage, but also less incentive for emissions reductions. Arguably, we observe a fair amount of this behaviour. Currently, about 12% or less of global CO2 emissions is subject to a carbon price (World Bank 2015). With the exception of some carbon taxes in Scandinavian countries, current prices are well below $40 – the US Environmental Protection Agency’s central estimate of the global social cost of carbon (SCC) – and all of the largest systems have prices below $15 (see also the contribution by Wang and Murisic in this book).4 One reason for individual jurisdictions to contribute too little to the global public good of climate mitigation is the free-rider effect: most of the benefits accrue to other 4 Prices as of 1 April 2015: California $13, EU ETS $8, RGGI $6, Japan carbon tax $2, Chinese provincial pilot ETS $5-8. (World Bank 2015). 300 Options for avoiding carbon leakage Carolyn Fischer jurisdictions, and those benefits can be enjoyed whether or not one contributes oneself. These types of incentives create challenges for an international climate agreement. However, many climate negotiators may take issue with the idea that their countries are seeking to free ride on the efforts of others. Indeed, many feel an ethical responsibility to contribute significant emissions reduction programmes, but not by using significant carbon prices when their trade partners are not facing similar policies. The US is an example – in its regulatory policy evaluations, it uses a global SCC, not a domestic (self- interested) SCC as one would expect of a free-rider. However, its main contributions involve regulatory standards for power plant emissions and vehicles, but not carbon pricing (see the chapter by Burtraw in this book). Thus, while free-riding would weaken intentions to take action, the fear of carbon leakage weakens the actions of the well- intentioned, thereby exacerbating the challenge of a strong international agreement on emissions mitigation. Still, there are some other options that countries or clubs of countries might take to address carbon leakage unilaterally. Most of the commonly proposed options are only suited for addressing competitiveness-related leakage. 2
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